OPTIONS- PART II
By Michael Craig
Since options are a key element of covered call investing, it is important that covered call investors have a good general understanding of options. The two most common questions that I receive are “Who buys the options?” and “Why are there periods when the option prices are high and other periods when they are low?” This segment will answer these two frequently asked questions, and hopefully give covered call writers further insight into the options market.
WHO BUYS THE OPTIONS?
The majority of the time, option calls are purchased by investors that are very bullish, sometimes excessively bullish, on a particular stock. The investors are hoping to make large percentage returns on their investments, while only using a small amount of capital. They are looking to “control” a large block of shares, while only having to provide a fraction of the money required to purchase them outright.
For example, XYZ Corp is trading at $50 a share, and the November $50 calls are selling for $4 a share. The option call buyer can “control” 100 shares of XYZ for only $400 (100 x $4), whereas if he or she wanted to buy the stock outright, the capital required would be $5,000 ($50 x 100). If the stock moves from $50 a share to $60 a share before the strike date, then the option call buyer will make a profit of $6 a share ($60-$50-$4). This is a gain of 150% for the option buyer, even though the stock is only up 20% during the time period.
It is these investors that are purchasing the option calls from you when you write a covered call. If they did not feel that the stock had a good chance of moving up, they would not buy the option call. Keep in mind though that purchasing a naked call is a very risky investment, and the majority of option calls expire worthless.
WHY ARE THERE PERIODS WHEN THE OPTION PRICES ARE HIGH AND OTHER PERIODS WHEN THEY ARE LOW?
There are some periods when option prices are much higher than normal, and other periods when option prices seem much lower than the normal. Much of the reason behind this has to deal with the investor sentiment of those buying the calls. If the investors buying the calls are more optimistic for the future, then option prices may go up, even though the price of the stock may not be moving. If investors are not as optimistic, or there is a lack of buyers, then the option prices may fall even though the stock price has not moved.
In periods where the market is doing well, investors are often willing to pay more for the option calls, because they feel that their chances of being profitable are increased. Conversely, in periods when the market is flat or moving down, investor enthusiasm is often diminished and the prices paid for option calls is also reduced. Therefore, when you see option prices increasing, it can be a sign that others feel this stock or the market in general has a bright short-term outlook.
For more information on options visit our Experienced Education section or click on the link provided http://www.winninginvestments.com/ViewArticle.asp?article=11. If you have any questions about options, please send them to the email address below and we will try and answer them.
